DLeon Inc.

, Part I
Financial Statements and Taxes

2-19 DONNA JAMISON, A 1997 GRADUATE OF THE UNIVERSITY OF FLORIDA WITH FOUR
YEARS OF BANKING EXPERIENCE, WAS RECENTLY BROUGHT IN AS ASSISTANT TO
THE CHAIRMAN OF THE BOARD OF DLEON INC., A SMALL FOOD PRODUCER THAT
OPERATES IN NORTH FLORIDA AND WHOSE SPECIALTY IS HIGH-QUALITY PECAN AND
OTHER NUT PRODUCTS SOLD IN THE SNACK-FOODS MARKET. DLEONS PRESIDENT,
AL WATKINS, DECIDED IN 2001 TO UNDERTAKE A MAJOR EXPANSION AND TO GO
NATIONAL IN COMPETITION WITH FRITO-LAY, EAGLE, AND OTHER MAJOR SNACK-
FOOD COMPANIES. WATKINS FELT THAT DLEONS PRODUCTS WERE OF A HIGHER
QUALITY THAN THE COMPETITIONS, THAT THIS QUALITY DIFFERENTIAL WOULD
ENABLE IT TO CHARGE A PREMIUM PRICE, AND THAT THE END RESULT WOULD BE
GREATLY INCREASED SALES, PROFITS, AND STOCK PRICE.
THE COMPANY DOUBLED ITS PLANT CAPACITY, OPENED NEW SALES OFFICES
OUTSIDE ITS HOME TERRITORY, AND LAUNCHED AN EXPENSIVE ADVERTISING
CAMPAIGN. DLEONS RESULTS WERE NOT SATISFACTORY, TO PUT IT MILDLY.
ITS BOARD OF DIRECTORS, WHICH CONSISTED OF ITS PRESIDENT AND VICE-
PRESIDENT PLUS ITS MAJOR STOCKHOLDERS (WHO WERE ALL LOCAL BUSINESS
PEOPLE), WAS MOST UPSET WHEN DIRECTORS LEARNED HOW THE EXPANSION WAS
GOING. SUPPLIERS WERE BEING PAID LATE AND WERE UNHAPPY, AND THE BANK
WAS COMPLAINING ABOUT THE DETERIORATING SITUATION AND THREATENING TO
CUT OFF CREDIT. AS A RESULT, WATKINS WAS INFORMED THAT CHANGES WOULD
HAVE TO BE MADE, AND QUICKLY, OR HE WOULD BE FIRED. ALSO, AT THE
BOARDS INSISTENCE DONNA JAMISON WAS BROUGHT IN AND GIVEN THE JOB OF
ASSISTANT TO FRED CAMPO, A RETIRED BANKER WHO WAS DLEONS CHAIRMAN AND
LARGEST STOCKHOLDER. CAMPO AGREED TO GIVE UP A FEW OF HIS GOLFING DAYS
AND TO HELP NURSE THE COMPANY BACK TO HEALTH, WITH JAMISONS HELP.
JAMISON BEGAN BY GATHERING THE FINANCIAL STATEMENTS AND OTHER DATA
GIVEN IN TABLES IC2-1, IC2-2, IC2-3, AND IC2-4. ASSUME THAT YOU ARE
JAMISONS ASSISTANT, AND YOU MUST HELP HER ANSWER THE FOLLOWING
QUESTIONS FOR CAMPO. (NOTE: WE WILL CONTINUE WITH THIS CASE IN
CHAPTER 3, AND YOU WILL FEEL MORE COMFORTABLE WITH THE ANALYSIS THERE,
BUT ANSWERING THESE QUESTIONS WILL HELP PREPARE YOU FOR CHAPTER 3.
PROVIDE CLEAR EXPLANATIONS, NOT JUST YES OR NO ANSWERS!)





TABLE IC2-1. BALANCE SHEETS

2002 2001
ASSETS
CASH $ 7,282 $ 57,600
ACCOUNTS RECEIVABLE 632,160 351,200
INVENTORIES 1,287,360 715,200
TOTAL CURRENT ASSETS $1,926,802 $1,124,000

GROSS FIXED ASSETS 1,202,950 491,000
LESS ACCUMULATED DEPRECIATION 263,160 146,200
NET FIXED ASSETS $ 939,790 $ 344,800
TOTAL ASSETS $2,866,592 $1,468,800

LIABILITIES AND EQUITY
ACCOUNTS PAYABLE $ 524,160 $ 145,600
NOTES PAYABLE 636,808 200,000
ACCRUALS 489,600 136,000
TOTAL CURRENT LIABILITIES $1,650,568 $ 481,600
LONG-TERM DEBT 723,432 323,432
COMMON STOCK (100,000 SHARES) 460,000 460,000
RETAINED EARNINGS 32,592 203,768
TOTAL EQUITY $ 492,592 $ 663,768
TOTAL LIABILITIES AND EQUITY $2,866,592 $1,468,800
















TABLE IC2-2. INCOME STATEMENTS

2002 2001
SALES $6,034,000 $3,432,000
COST OF GOODS SOLD 5,528,000 2,864,000
OTHER EXPENSES 519,988 358,672
TOTAL OPERATING COSTS
EXCLUDING DEPRECIATION AND AMORTIZATION $6,047,988 $3,222,672
EBITDA ($ 13,988) $ 209,328
DEPRECIATION AND AMORTIZATION 116,960 18,900
EBIT ($ 130,948) $ 190,428
INTEREST EXPENSE 136,012 43,828
EBT ($ 266,960) $ 146,600
TAXES (40%) (106,784)
a
58,640
NET INCOME ($ 160,176) $ 87,960

EPS ($1.602) $0.880
DPS $0.110 $0.220
BOOK VALUE PER SHARE $4.926 $6.638
STOCK PRICE $2.250 $8.500
SHARES OUTSTANDING 100,000 100,000
TAX RATE 40.00% 40.00%
LEASE PAYMENTS 40,000 40,000
SINKING FUND PAYMENTS 0 0

NOTE:
a
THE FIRM HAD SUFFICIENT TAXABLE INCOME IN 2000 AND 2001 TO OBTAIN ITS FULL TAX
REFUND IN 2002.
TABLE IC2-3. STATEMENT OF RETAINED EARNINGS, 2002

BALANCE OF RETAINED EARNINGS, 12/31/01 $203,768
ADD: NET INCOME, 2002 (160,176)
LESS: DIVIDENDS PAID (11,000)
BALANCE OF RETAINED EARNINGS, 12/31/02 $ 32,592


TABLE IC2-4. STATEMENT OF CASH FLOWS, 2002

OPERATING ACTIVITIES
NETINCOME ($160,176)
ADDITIONS (SOURCES OF CASH)
DEPRECIATION AND AMORTIZATION 116,960
INCREASE IN ACCOUNTS PAYABLE 378,560
INCREASE IN ACCRUALS 353,600
SUBTRACTIONS (USES OF CASH)
INCREASEIN ACCOUNTS RECEIVABLE (280,960)
INCREASEIN INVENTORIES (572,160)
NETCASH PROVIDED BY OPERATING ACTIVITIES ($164,176)

LONG-TERM INVESTING ACTIVITIES
CASHUSED TO ACQUIRE FIXED ASSETS ($711,950)

FINANCING ACTIVITIES
INCREASE IN NOTES PAYABLE $436,808
INCREASE IN LONG-TERM DEBT 400,000
PAYMENTOF CASH DIVIDENDS (11,000)
NET CASH PROVIDED BY FINANCING ACTIVITIES $825,808
SUM: NET DECREASE IN CASH ($ 50,318)
PLUS: CASH AT BEGINNING OF YEAR 57,600
CASH AT END OF YEAR $ 7,282

A. WHAT EFFECT DID THE EXPANSION HAVE ON SALES, NET OPERATING PROFIT
AFTER TAXES (NOPAT), NET OPERATING WORKING CAPITAL (NOWC), TOTAL
INVESTOR-SUPPLIED OPERATING CAPITAL, AND NET INCOME?

ANSWER: [S2-1 THROUGH S2-9 PROVIDE BACKGROUND INFORMATION. THEN SHOW S2-10
THROUGH S2-14 HERE.] SALES INCREASED BY $2,602,000.

NOPAT
02
= EBIT(1 - TAX RATE)
= (-$130,948)(0.6) = ($78,569).

NOPAT
01
= $190,428(0.6) = $114,257.

ANOPAT = ($78,569) - $114,257 = ($192,826).

NOPAT DECREASED BY $192,826.

NOWC
02
=
|
.
|

\
|
+
|
.
|

\
|
+ + ACCRUALS
PAYABLE
ACCOUNTS
S INVENTORIE
RECEIVABLE
ACCOUNTS
CASH
= ($7,282 + $632,160 + $1,287,360) - ($524,160 + $489,600)
= $913,042.

NOWC
01
= ($57,600 + $351,200 + $715,200) - ($145,600 + $136,000)
= $842,400.

ANOWC = $913,042 - $842,400 = $70,642.

NET OPERATING WORKING CAPITAL INCREASED BY $70,642.

OC
02
= NET OPERATING WORKING CAPITAL + NET PLANT AND EQUIPMENT
= $913,042 + $939,790 = $1,852,832.

OC
01
= $842,400 + $344,800 = $1,187,200.

AOC = $1,852,832 - $1,187,200 = $665,632.

TOTAL INVESTOR-SUPPLIED OPERATING CAPITAL INCREASED SUBSTANTIALLY BY
$665,632 FROM 2001 TO 2002.

NI
02
NI
01
= ($160,176) - $87,960 = ($248,136).

THERE WAS A BIG DROP, -$248,136, IN NET INCOME DURING 2002.

B. WHAT EFFECT DID THE COMPANYS EXPANSION HAVE ON ITS NET CASH FLOW,
OPERATING CASH FLOW, AND FREE CASH FLOW?

ANSWER: [SHOW S2-15 AND S2-16 HERE.]

NCF
02
= NI + DEP AND AMORT = ($160,176) + $116,960 = ($43,216).

NCF
01
= $87,960 + $18,900 = $106,860.

OCF
02
= EBIT(1 - T) + DEP AND AMORT = (-$130,948)(0.6) + $116,960
= $38,391.

OCF
01
= ($190,428)(0.6) + $18,900 = $133,157.

FCF
02
= NOPAT - NET INVESTMENT IN OPERATING CAPITAL
= (-$78,569) - ($1,852,832 - $1,187,200)
= (-$78,569) - $665,632 = ($744,201).

NCF IS NEGATIVE IN 2002, BUT IT WAS POSITIVE IN 2001. OCF IS POSITIVE
IN 2002, BUT IT DECREASED BY OVER 70 PERCENT FROM ITS 2001 LEVEL.
FREE CASH FLOW WAS -$744,201 IN 2002.


C. JAMISON ALSO HAS ASKED YOU TO ESTIMATE DLEONS EVA. SHE ESTIMATES
THAT THE AFTER-TAX COST OF CAPITAL WAS 10 PERCENT IN 2001 AND
13 PERCENT IN 2002.

ANSWER: [SHOW S2-17 THROUGH S2-19 HERE.]

EVA
02
= EBIT(1 - T) - AFTER-TAX COST OF OPERATING CAPITAL
= (-$130,948)(0.6) - ($1,852,832)(0.13)
= ($319,437).

EVA
01
= EBIT(1 - T) - AFTER-TAX COST OF OPERATING CAPITAL
= ($190,428)(0.6) - ($1,187,200)(0.10)
= ($4,463).

IN 2001, EVA WAS SLIGHTLY NEGATIVE; HOWEVER IN 2002 EVA WAS
SIGNIFICANTLY NEGATIVE.

D. LOOKING AT DLEONS STOCK PRICE TODAY, WOULD YOU CONCLUDE THAT THE
EXPANSION INCREASED OR DECREASED MVA?

ANSWER: [SHOW S2-20 HERE.] DURING THE LAST YEAR, STOCK PRICE HAS DECREASED BY
OVER 73 PERCENT, THUS ONE WOULD CONCLUDE THAT THE EXPANSION HAS
DECREASED MVA.


E. DLEON PURCHASES MATERIALS ON 30-DAY TERMS, MEANING THAT IT IS
SUPPOSED TO PAY FOR PURCHASES WITHIN 30 DAYS OF RECEIPT. JUDGING FROM
ITS 2002 BALANCE SHEET, DO YOU THINK DLEON PAYS SUPPLIERS ON TIME?
EXPLAIN.
IF NOT, WHAT PROBLEMS MIGHT THIS LEAD TO?

ANSWER: [SHOW S2-21 HERE.] DLEON PROBABLY DOES NOT PAY ITS SUPPLIERS ON TIME
JUDGING FROM THE FACT THAT ITS ACCOUNTS PAYABLES BALANCE INCREASED BY
260 PERCENT FROM THE PAST YEAR, WHILE SALES INCREASED BY ONLY 76
PERCENT. COMPANY RECORDS WOULD SHOW IF THEY PAID SUPPLIERS ON TIME.
BY NOT PAYING SUPPLIERS ON TIME, DLEON IS STRAINING ITS RELATIONSHIP
WITH THEM. IF DLEON CONTINUES TO BE LATE, EVENTUALLY SUPPLIERS WILL
CUT THE COMPANY OFF AND PUT IT INTO BANKRUPTCY.


F. DLEON SPENDS MONEY FOR LABOR, MATERIALS, AND FIXED ASSETS
(DEPRECIATION) TO MAKE PRODUCTS, AND STILL MORE MONEY TO SELL THOSE
PRODUCTS. THEN, IT MAKES SALES THAT RESULT IN RECEIVABLES, WHICH
EVENTUALLY RESULT IN CASH INFLOWS. DOES IT APPEAR THAT DLEONS SALES
PRICE EXCEEDS ITS COSTS PER UNIT SOLD? HOW DOES THIS AFFECT THE CASH
BALANCE?

ANSWER: [SHOW S2-22 HERE.] IT DOES NOT APPEAR THE DLEONS SALES PRICE
EXCEEDS ITS COSTS PER UNIT SOLD AS INDICATED IN THE INCOME STATEMENT.
THE COMPANY IS SPENDING MORE CASH THAN IT IS TAKING IN AND, AS A
RESULT, THE CASH ACCOUNT BALANCE HAS DECREASED.


G. SUPPOSE DLEONS SALES MANAGER TOLD THE SALES STAFF TO START OFFERING
60-DAY CREDIT TERMS RATHER THAN THE 30-DAY TERMS NOW BEING OFFERED.
DLEONS COMPETITORS REACT BY OFFERING SIMILAR TERMS, SO SALES REMAIN
CONSTANT. WHAT EFFECT WOULD THIS HAVE ON THE CASH ACCOUNT? HOW WOULD
THE CASH ACCOUNT BE AFFECTED IF SALES DOUBLED AS A RESULT OF THE
CREDIT POLICY CHANGE?

ANSWER: [SHOW S2-23 HERE.] BY EXTENDING THE SALES CREDIT TERMS, IT WOULD TAKE
LONGER FOR DLEON TO RECEIVE ITS MONEY--ITS CASH ACCOUNT WOULD
DECREASE AND ITS ACCOUNTS RECEIVABLE WOULD BUILD UP. BECAUSE
COLLECTIONS WOULD SLOW, ACCOUNTS PAYABLE WOULD BUILD UP TOO.
INVENTORY WOULD HAVE TO BE BUILT UP AND POSSIBLY FIXED ASSETS TOO
BEFORE SALES COULD BE INCREASED. ACCOUNTS RECEIVABLE WOULD RISE AND
CASH WOULD DECLINE. MUCH LATER, WHEN COLLECTIONS INCREASED CASH WOULD
RISE. DLEON WOULD PROBABLY NEED TO BORROW OR SELL STOCK TO FINANCE
THE EXPANSION.


H. CAN YOU IMAGINE A SITUATION IN WHICH THE SALES PRICE EXCEEDS THE COST
OF PRODUCING AND SELLING A UNIT OF OUTPUT, YET A DRAMATIC INCREASE IN
SALES VOLUME CAUSES THE CASH BALANCE TO DECLINE?

ANSWER: THIS SITUATION IS LIKELY TO OCCUR AS SUGGESTED IN THE SECOND PART OF
THE ANSWER TO QUESTION G.


I. DID DLEON FINANCE ITS EXPANSION PROGRAM WITH INTERNALLY GENERATED
FUNDS (ADDITIONS TO RETAINED EARNINGS PLUS DEPRECIATION) OR WITH
EXTERNAL CAPITAL? HOW DOES THE CHOICE OF FINANCING AFFECT THE
COMPANYS FINANCIAL STRENGTH?

ANSWER: [SHOW S2-24 HERE.] DLEON FINANCED ITS EXPANSION WITH EXTERNAL
CAPITAL RATHER THAN INTERNALLY GENERATED FUNDS. IN PARTICULAR, DLEON
ISSUED LONG-TERM DEBT RATHER THAN COMMON STOCK, WHICH REDUCED ITS
FINANCIAL STRENGTH AND FLEXIBILITY.


J. REFER TO TABLES IC2-2 AND IC2-4. SUPPOSE DLEON BROKE EVEN IN 2002 IN
THE SENSE THAT SALES REVENUES EQUALED TOTAL OPERATING COSTS PLUS
INTEREST CHARGES. WOULD THE ASSET EXPANSION HAVE CAUSED THE COMPANY
TO EXPERIENCE A CASH SHORTAGE THAT REQUIRED IT TO RAISE EXTERNAL
CAPITAL?

ANSWER: [SHOW S2-25 HERE.] EVEN IF DLEON HAD BROKEN EVEN IN 2002, THE FIRM
WOULD HAVE HAD TO FINANCE AN INCREASE IN ASSETS.
K. IF DLEON STARTED DEPRECIATING FIXED ASSETS OVER 7 YEARS RATHER THAN
10 YEARS, WOULD THAT AFFECT (1) THE PHYSICAL STOCK OF ASSETS, (2) THE
BALANCE SHEET ACCOUNT FOR FIXED ASSETS, (3) THE COMPANYS REPORTED NET
INCOME, AND (4) ITS CASH POSITION? ASSUME THE SAME DEPRECIATION
METHOD IS USED FOR STOCKHOLDER REPORTING AND FOR TAX CALCULATIONS, AND
THE ACCOUNTING CHANGE HAS NO EFFECT ON ASSETS PHYSICAL LIVES.

ANSWER: [SHOW S2-26 HERE.] THIS WOULD HAVE NO EFFECT ON THE PHYSICAL STOCK OF
THE ASSETS; HOWEVER, THE BALANCE SHEET ACCOUNT FOR NET FIXED ASSETS
WOULD DECLINE BECAUSE ACCUMULATED DEPRECIATION WOULD INCREASE DUE TO
DEPRECIATING ASSETS OVER 7 YEARS VERSUS 10 YEARS. BECAUSE
DEPRECIATION EXPENSE WOULD INCREASE, NET INCOME WOULD DECLINE.
FINALLY, THE FIRMS CASH POSITION WOULD INCREASE, BECAUSE ITS TAX
PAYMENTS WOULD BE REDUCED.


L. EXPLAIN HOW EARNINGS PER SHARE, DIVIDENDS PER SHARE, AND BOOK VALUE
PER SHARE ARE CALCULATED, AND WHAT THEY MEAN. WHY DOES THE MARKET
PRICE PER SHARE NOT EQUAL THE BOOK VALUE PER SHARE?

ANSWER: NET INCOME DIVIDED BY SHARES OUTSTANDING EQUALS EARNINGS PER SHARE.
DIVIDENDS DIVIDED BY SHARES OUTSTANDING EQUALS DIVIDENDS PER SHARE,
WHILE BOOK VALUE PER SHARE IS CALCULATED AS TOTAL COMMON EQUITY
DIVIDED BY SHARES OUTSTANDING.
MARKET PRICE PER SHARE DOES NOT EQUAL BOOK VALUE PER SHARE. THE
MARKET VALUE OF A STOCK REFLECTS FUTURE PROFITABILITY, WHILE BOOK
VALUE PER SHARE REPRESENTS HISTORICAL COST.

M. EXPLAIN BRIEFLY THE TAX TREATMENT OF (1) INTEREST AND DIVIDENDS PAID,
(2) INTEREST EARNED AND DIVIDENDS RECEIVED, (3) CAPITAL GAINS, AND (4)
TAX LOSS CARRY-BACK AND CARRY-FORWARD. HOW MIGHT EACH OF THESE ITEMS
IMPACT DLEONS TAXES?

ANSWER: [SHOW S2-27 THROUGH S2-30 HERE.] FOR A BUSINESS, INTEREST PAID IS
CONSIDERED AN EXPENSE AND IS PAID OUT OF PRE-TAX INCOME. THEREFORE,
INTEREST PAID IS TAX DEDUCTIBLE FOR BUSINESSES. FOR INDIVIDUALS,
INTEREST PAID IS GENERALLY NOT TAX DEDUCTIBLE, WITH THE NOTABLE
EXCEPTION BEING LIMITED TAX DEDUCTIBILITY ON HOME MORTGAGE INTEREST.
DIVIDENDS PAID BY A BUSINESS ARE PAID OUT OF AFTER-TAX INCOME.
INTEREST EARNED, WHETHER BY A BUSINESS OR INDIVIDUAL, IS TAXABLE
INCOME AND SUBJECT TO STANDARD INCOME TAXES, EXCEPT FOR SOME STATE AND
LOCAL GOVERNMENT DEBT INTEREST. DIVIDENDS RECEIVED ARE FULLY TAXED AS
ORDINARY INCOME FOR INDIVIDUALS, CREATING A DOUBLE TAXATION OF
DIVIDENDS. A PORTION OF DIVIDENDS RECEIVED BY CORPORATIONS IS TAX
EXCLUDABLE, IN ORDER TO AVOID TRIPLE TAXATION.
CAPITAL GAINS ARE DEFINED AS THE PROFITS FROM THE SALE OF AN ASSET
NOT USED IN THE NORMAL COURSE OF BUSINESS. FOR INDIVIDUALS, CAPITAL
GAINS ON ASSETS ARE TAXED AS ORDINARY INCOME IF HELD FOR LESS THAN A
YEAR, AND AT THE CAPITAL GAINS RATE IF HELD FOR MORE THAN A YEAR.
CORPORATIONS FACE SOMEWHAT DIFFERENT RULES. CAPITAL GAINS FOR
CORPORATIONS ARE TAXED AS ORDINARY INCOME. TAX LOSS CARRY-BACK AND
CARRY-FORWARD PROVISIONS ALLOW BUSINESSES TO USE A LOSS IN THE CURRENT
YEAR TO OFFSET PROFITS IN PRIOR YEARS (2 YEARS), AND IF LOSSES HAVENT
BEEN COMPLETELY OFFSET BY PAST PROFITS THEY CAN BE CARRIED FORWARD TO
OFFSET PROFITS IN THE FUTURE (20 YEARS).
DLEON PAID INTEREST EXPENSE OF $136,012 WHICH WAS USED TO FURTHER
LOWER ITS TAX LIABILITY RESULTING IN A TAX CREDIT OF $106,784 FOR A
NET LOSS OF -$160,176. HOWEVER, BECAUSE OF THE TAX LOSS CARRY-BACK
AND CARRY-FORWARD PROVISION DLEON WAS ABLE TO OBTAIN ITS FULL TAX
REFUND IN 2002 (AS THE FIRM HAD SUFFICIENT TAXABLE INCOME IN 2000 and
2001).